Reason Foundation

Defending Limits on State Tax Powers

The U.S. Senate holds hearings Wednesday on the so-called Market Fairness Act (S. 1832), which would be better dubbed the “Consumer and Enterprise Unfairness Act,” as it seeks to undo a critical requirement that prevents states from engaging in interstate tax plunder.

In a series of court decisions that stretch back to the 1950s, the courts have consistently affirmed that a business must have a physical presence within a state in order to be compelled to collect sales taxes set by that state and any local jurisdiction.

That meant catalogue and mail order businesses were not required to collect sales tax from customers in any other state but their own. The three major decision that serve as the legal foundation for this rule, including Quill v. North Dakota,the case cited most frequently.

Quill left room for Congress to act, which indeed it is doing with the Market Fairness Act. The impetus for the act has nothing to with the catalogue business, however. Rather, it’s the estimated $200 billion in annual Internet retail sales, a significant portion of which escapes taxation, that’s got the states pushing Congress to take a sledgehammer to a fundamental U.S. tax principle that has served the purpose of interstate commerce since 1787.

That’s why the Marketplace Fairness Act is so troublesome. While indeed Congress has the power to create an state-to-state tax structure, it may be imprudent to do so. In seeking to close what it disingenuously calls a “loophole” that allows Internet sales to remain tax-free, it bulldozes a vital element of commerce law that protects consumers from taxation from other jurisdictions.

That year, of course, is when the U.S. Constitution replaced the Articles of Confederation. One of the flaws of the Articles was that it permitted each of the states to tax residents of others. Rather than get the budding nation closer to the nominal goal of confederation, it was endangering the expansion of vital post-colonial commerce by creating 13 tax fiefdoms and protectorates. The authors of the Constitution wisely addressed this by vesting the regulation of interstate commerce in the federal government.

And that protection is as necessary as ever. As the Tax Foundation’s Joseph Henchman will remind Congress today in his testimony, states have every incentive to shift tax burdens from their own residents to others elsewhere. As an example, take all those taxes attached to hotel and car rental bills.

The Marketplace Fairness Bill puts great stock in the idea that software and technology can relived the “burden” that, according to the courts, state and local tax compliance places on out-of-state business. But even sales tax complexity can’t be solved with the literal click of the mouse. It’s more than just the 9,600 sales tax jurisdictions that need to be factored in. Tax rules differ state to state, city to city and town to town. Sometimes a candy bar is taxed, sometimes it’s not. Every August, some states declare a “sales tax holiday weekend” in hopes of boosting back-to-school business. Dates can vary. Bottom line, there’s no reliable plug-and-play software for this. Overstock.com chairman and CEO Patrick Byrne has said it cost his company $300,000 and months of man-hours to create a solution.

The Marketplace Fairness Bill takes tax policy in the wrong direction, setting up a classic slippery slope that will see states becoming more and more predatory. What’s needed instead is an alternative that respects both state’s rights and the limits set by the Constitution.

But there will be no real progress until state legislators admit what they are trying to do: collect more taxes. That at least makes the dialogue honest. Then the question becomes whether the initiative is necessary to begin with. After that, more reasonable constructs include an origin-based tax system, building on the framework that exists today. When I purchase an item in Sugar Land, Tex, I pay sales tax to Texas and Sugar Land. When I travel to Los Angeles and buy a souvenir from the Universal Studios tour, I pat sales taxes levied there. A more sensible tax structure allows merchants to comply with the tax rules in their own states.

The only objection comes from legislators in high sales tax states who complain origin-based taxation gives businesses that locate in states such as Oregon and New Hampshire, two of five that charge no sales tax, an advantage. My affable reply is “Why yes, it does. Doesn't it?."

A low-tax policy is one way states can compete constructively for commerce and economic growth. Consumers and businesses would be much better off if states looked at e-commerce as an opportunity to boost their economies by welcoming Internet enterprises instead of treating them, and their customers, as just another cash pump.